Chapter 12- Inventory Management

Objective of inventory management
Strike a balance between inventory investment and customer service
Four functions of inventory
1. To provide a selection of goods for anticipated customer demand and to separate the firm from fluctuations in that demand
2. Decouple various parts of the production process
3. Take advantage of quantity discounts
4. Hedge against inflation
Types of inventory
Raw material inventory; work-in-process inventory; maintenance/repair/operating supply (MRO) inventory, and finished-goods inventory
Raw material inventory
Materials that are usually purchased but have yet to enter the manufacturing process
Work-in-process (WIP) inventory
Products or components that are no longer raw materials but have yet to become finished products
Maintenance/repair/operating (MRO) inventory
Maintenance, repair, and operating materials
Finished-goods inventory
end item ready to be sold, but still an asset on the company’s books
ABC analysis
Method for dividing on-hand inventory into three classifications based on annual dollar volume
A = high dollar volume
B = medium ” ”
C = low ” “
Cycle counting
Continuing reconciliation of inventory with inventory records
advantages of cycle counting
– eliminates shutdown and interruption of production necessary for annual physical inventories
– eliminates annual inventory adjustments
– trained personnel audit the accuracy of inventory
– allows cause of errors to be identified and remedial action to be taken
– maintains accurate inventory records
Retail inventory that is unaccounted for between receipt and sale
Small amount of theft
Independent demand
demand for item is independent of the demand for any other item in inventory
Holding costs
Costs associated with holding or “carrying” inventory over time
Ordering cost
Cost of ordering process; includes costs of supplies, forms, order processing, purchasing, clerical support, etc.
setup cost
cost to prepare a machine or process for manufacturing an order
setup time
time required to prepare a machine or process for production
Three independent demand models
basic economic order quantity (EOQ) model; production order quantity model; quantity discount model
Economic order quantity (EOQ) model
inventory-control technique that minimizes the total of ordering and holding costs
EOQ model assumptions
– demand for an item is known, reasonably constant, and independent of decisions for other items
– lead time is known and consistent
– receipt of inventory is instantaneous and complete
– quantity discounts are not possible
– only variable costs are the cost of setting up or placing an order and the cost of holding or storing inventory over time
– stockouts (shortages) can be completely avoided if orders are placed at the right time
Optimal order quantity
Optimal order quantity
Point where the ordering-cost curve and the carrying-cost curve intersect
Annual setup cost
number of orders placed per year x setup or order cost per order

((D/Q)) (S)

Annual holding cost
average inventory level x holding cost per unit per year

((Q/2)) (H)

expected number of orders
N = (D / Q)
Expected time between orders
T = (number of working days per year / N)
total annual cost
total annual cost
Setup (order) cost + holding cost
giving satisfactory answers even with substantial variation in the parameters; EOQ is a robust model
lead time
In purchasing system, the time between placing an order and receiving it; in production system, the wait, move, queue, setup, and run times for each component produced
Reorder point (ROP)
Reorder point (ROP)
inventory level (point) at which action is taken to replenish the stocked item

ROP = d x L

Safety stock (ss)
Extra stock to allow for uneven demand; a buffer
Production order quantity model
economic order quantity technique applied to production orders
probabilistic model
Statistical model applicable when product demand or any other variable is not known but can be specified by means of a probability distribution

annual stockout costs = (sum of the units short for each demand level) x (probability of that demand level) x (the stockout cost/unit) x (the number of orders per year)

demand is variable and lead time is constant
demand is variable and lead time is constant
ROP = (average daily demand x lead time in days) + Z(standard deviation of demand per day x standard deviation lead time in days)
demand is constant and lead time is variable
ROP = (daily demand x average lead time in days) + Z x daily demand x standard deviation of lead time in days
both demand and lead time are variable
ROP = (average daily demand x average lead time in days) + Z(standard deviation of demand per day x standard deviation lead time in days)
single-period inventory model
System for ordering items that have little or no value at the end of a sales period (perishables)

-underestimated: Cs = Sales price per unit – cost per unit
– overestimated: Co = cost per unit – salvage value per unit

Service level
Probability of not stocking out
Cs / (Cs + Co)
Fixed-period (P) system
System in which inventory orders are made at regular time intervals